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Ukraine war tips UK economy towards the edge


IT’S not often that I agree with the Rowntree Foundation but its recent report that the UK faces the worst standard of living crisis since the 1970s unfortunately mirrors my own conclusions. In fact, it may well be underestimating the risks as it seems to focus on the cost of living rather than a more holistic analysis including monetary and fiscal implications, which in my view is where the real danger lies. 

That’s where my agreement with the Rowntree Foundation ends, however. Its solution of more state intervention, which it constantly advocates, is what has got us into this mess. More of the same certainly won’t help. 

Regardless of one’s view of the Ukrainian tragedy, this could not have happened at a worse time for the West, weakened by years of self-inflicted poor policy choices. Unfortunately, this tragedy has very real consequences not just for Russia and Ukraine, but for us all. Has the Government really thought through the second derivative?

Even before the Ukraine crisis British (and also European and American) consumers were being hit from all sides. Rapidly rising inflation, rising taxation, the impact of woke economics and net zero, lockdown-induced economic distress, subsequent supply shortages and a pre-war 40 per cent energy bill hike were all beginning to bite.  

Most of this pain was not down to bad luck but directly down to policy choices over many years. Many pre-date this Government. Some of these poor choices were global, some national. Self-inflicted because Governments were severely weakened firstly over a decade ago by the impact of the global financial crisis, then subsequently by lockdown, energy policy, excessive public spending, high taxation and unorthodox monetary response. 

Central banks and indeed politicians believed expansive monetary policy was pretty well a free bet. It helped fund Government deficits, enabled higher public spending (which in this author’s view ultimately undermines long-term growth), reflated the banks via higher asset prices – and the icing on the cake, from their perspective, was that inflation was low, or apparently so. 

But this destruction of the real value of money was the start of the delusion. A delusion that Governments could print money at will to fund lockdown, and that ever greater public spending was risk-free. Lockdown put this policy into overdrive as quantitative easing was used in effect to fund the entire cost of Covid.

In fairness, there was a fig leaf of intellectual credibility to monetary policy (QE and near zero interest rates) when global inflation was apparently very low. I say apparently as inflation in some things was low (trips to Aldi and Primark aided by cheap Chinese labour) but other things not so, for example more rarefied product like school fees or trips to the theatre, or things not measured by CPI like real estate, equity investments, and fine wine and fast cars. Thus the real inflationary outcomes were far more nuanced and complex than the headlines suggested.

Make no mistake, the last decade has been built on sand with apparent wealth and great prosperity. Much of this is not a result of productive gain but more the impact of quantitative easing and near zero interest rates giving a wealth illusion as investors chased property and stock market assets. 

Prior to the outbreak of war that illusion was already displaying signs of cracking as central banks were forced, oh so cautiously, to raise rates just a bit. In the UK’s case from 0.1 per cent to 0.5 per cent. The problem being we’d all become used to free money and if the bank raised rates too quickly it would kill both asset prices and cause recession. This was what I have referred to as the treadmill trade – once on, it’s very hard to get off.

Then inflation started to increase, not just in the UK but throughout the EU and US. Monetary policy was caught without any clothes. When inflation hits 5.5 per cent and interest rates are 0.5 per cent, something is amiss. 

Now the impact of war has caused oil to spike from $69 a barrel in November to $129 today. Similarly the current gas spot is over 50 per cent above the currently implemented 40 per cent higher energy price cap. 

OFGEM, the utilities regulator, reckons average utility bills will increase from £1,277 to £1,971 this year. If the current spot should prevail, domestic energy bills might be £2,700 next. The impact is clear and goes well beyond utility bills to food and travel. Indeed anything that uses much power is going to cost a whole lot more. This risks outright recession and real pain.

There is never a good time for recession but when the country is already severely weakened it is potentially threatening. Recession means lowered tax receipts, higher social spending and a ballooning fiscal deficit, all when the current deficit is desperately unstable. 

Consider the following. The Bank of England was founded in 1694. It took 312 years, until early 2006, for the national debt to breach the £500billion mark. Then the financial crisis came and within four years the figure had doubled to £1trillion. Then there was that self-styled ‘austerity’. So austere that by the eve of lockdown, just eight years later, public debt had almost doubled again to £1.8trillion. Today, just two years later, post lockdown, another £500billion has been added with current debt at £2.3trillion or 95 per cent GDP.

The official forecasters believed the rate of increase in public debt would fall sharply as the economy bounced back from lockdown. This seemed overly optimistic to me. Now war and subsequent sanctions will almost certainly tip the UK and European economies into recession. This will directly result in stagnating tax receipts and increased public spending. 

Expect a deficit of potentially £250bn in 2023 if the economy does go into recession. Who will buy those gilts? More QE? Is that really credible when inflation is escalating? Will the government resort to a further fiscal stimulus? That’s the response to any pain these days, often compounding error and damaging the long term for short-term expediency.

It might not show up in the official data for a bit because the post lockdown base is so low, but I find it hard to see a recession being avoided unless there is a very speedy resolution to matters in Ukraine – which seems rather unlikely, unfortunately. Further, prior to this crisis the consensus of inflationary expectations of around 6-7 per cent, which I believed were too low, are very likely to significantly exceed 10 per cent, and potentially quite a bit more.

But the Bank of England has argued that it is only temporary: it will be back down to 2 per cent next year. Does the Governor believe that? 

The truth is that the free bet of near-zero interest rates and money printing was allowed to go on for far too long. A decade after the financial crash and rates were still near zero here, and negative in much of the EU. They thought it a free bet. Unless inflationary pressures dissipate, and it will need a miracle for that, economic policy is now in a very dangerous space indeed.  

The problem is that the historic method of taming inflation is to raise interest rates. But will/can the central bank really do that in the eye of an energy crisis and inflationary shock? Increase rates by more than a tokenistic amount and it seriously risks adding fuel to the recessionary fire, lowering tax receipts and increasing the deficit, perhaps leading to more debt monetisation.

But if the Bank doesn’t raise rates, how credible are 0.5 per cent interest rates if inflation exceeds 10 per cent, which it likely will? 

This is the classic catch 22, but if we have learned anything about our political class over the last decade it is they are big on virtue signalling, big on ‘smoothing pain’ as a short-term fix, but rather poor at resolving structural problems. 

I’ll bet they will argue inflation is temporary, therefore prioritising growth over inflation. That’s a very dangerous bet given the strategic mess we’ve got ourselves into. The Ukrainian tragedy simply amplifies the structural problems Britain and much of the west faces, but the underlying malaise had set in well before that crisis.

This appeared in Brexit Watch on March 9, 2022, and is republished by kind permission.

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Ewen Stewart
Ewen Stewart
Ewen Stewart is a City economist who runs the consultancy Walbrook Economics. He is director of the think tank Global Britain and his work is widely published in economics and political journals.

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